SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 26, 1999
Commission File No. 0-27742
CYLINK CORPORATION
(Exact name of registrant as specified in its charter)
California 95-3891600
State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3131 Jay Street
Santa Clara, CA 95054
(Address of principal executive offices)
(408) 855-6100
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
As of November 8, 1999, there were 29,730,000 shares of the Registrant's common
stock outstanding.
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CYLINK CORPORATION
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 26, 1999
INDEX
Page
----
Facing Sheet 1
Index 2
Part I Financial information
Item 1 Financial Statements and Supplementary Data
a) Condensed Consolidated Balance Sheets at September
26, 1999 and December 31, 1998 3
b) Condensed Consolidated Statements of Operations for
the three and nine months ended September 26, 1999
and September 27, 1998 4
c) Condensed Consolidated Statement of Cashflows for
the nine months ended September 26, 1999 and
September 27, 1998 5
d) Notes to Condensed Consolidated Financial
Statements 6
Item 2 Management's discussion and analysis of financial
condition and results of operations 9
Part II Other Information 21
Signature 22
Exhibit Exhibit 27.1, Financial data schedule 23
2
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
--------------------
<TABLE>
CYLINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data; unaudited)
<CAPTION>
September 26, December 31,
1999 1998
--------- ---------
<S> <C> <C>
Assets
Current assets:
Cash and cash equivalents $ 38,180 $ 46,575
Accounts receivable, net of allowances of $1,425 and $1,251 14,974 7,958
Note receivable -- 3,545
Inventories 5,102 10,289
Deferred income taxes 4,504 4,495
Other current assets 2,971 6,675
--------- ---------
Total current assets 65,731 79,537
Restricted cash 1,400 --
Property and equipment, net 8,336 5,731
Acquired technology, goodwill and other intangibles 3,873 5,341
Notes receivable from employees or former employees 3,282 2,558
Other assets 1,203 1,151
--------- ---------
$ 83,825 $ 94,318
========= =========
Liabilities and Shareholders' Equity
Current liabilities:
Current portion of lease obligations and long-term debt $ 29 $ 120
Accounts payable 6,381 3,656
Accrued liabilities 6,616 8,230
Accrued liabilities related to discontinued operations -- 3,878
Income taxes payable 1,045 1,091
Deferred revenue 2,175 1,975
--------- ---------
Total current liabilities 16,246 18,950
--------- ---------
Capital lease obligations and long-term debt 114 147
--------- ---------
Commitments and Contingencies (Note 9)
Shareholders' equity:
Preferred stock, $.01 par value; 5,000,000 shares authorized
none issued or outstanding -- --
Common stock, $.01 par value; 40,000,000 shares authorized
29,573,000 and 29,115,000 shares issued and outstanding . 296 291
Additional paid-in capital 126,237 123,929
Deferred compensation (1,989) (167)
Accumulated other comprehensive loss (197) (61)
Accumulated deficit (56,882) (48,771)
--------- ---------
Total shareholders' equity 67,465 75,221
--------- ---------
$ 83,825 $ 94,318
========= =========
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
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<TABLE>
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share data; unaudited)
<CAPTION>
Three Months Ended Nine Months Ended
------------------------ ------------------------
September 26, September 27, September 26, September 27,
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenue $ 15,092 $ 12,130 $ 42,186 $ 32,555
Cost of revenue 4,157 5,924 13,038 12,545
-------- -------- -------- --------
Gross profit 10,935 6,206 29,148 20,010
-------- -------- -------- --------
Operating expenses:
Research and development, net 3,783 6,222 11,276 12,037
Selling and marketing 6,424 6,170 18,061 17,950
General and administrative 3,800 2,452 9,716 5,782
Amortization of purchased intangibles 724 679 2,084 2,038
-------- -------- -------- --------
Total operating expenses 14,731 15,523 41,137 37,807
-------- -------- -------- --------
Loss from operations (3,796) (9,317) (11,989) (17,797)
Other income (expense):
Interest income, net 420 542 1,356 1,381
Royalty and other income (expense), net 138 32 276 (83)
-------- -------- -------- --------
558 574 1,632 1,298
-------- -------- -------- --------
Loss from continuing operations before income taxes (3,238) (8,743) (10,357) (16,499)
Benefit for income taxes -- (3,060) -- (5,774)
-------- -------- -------- --------
Loss from continuing operations (3,238) (5,683) (10,357) (10,725)
Loss from discontinued operations,
net of tax (Note 2) -- -- -- (259)
Gain on disposal of discontinued operations,
net of tax (Note 2) 2,246 -- 2,246 22,776
-------- -------- -------- --------
Net income (loss) $ (992) $ (5,683) $ (8,111) $ 11,792
======== ======== ======== ========
Earnings (loss) per share - basic:
Continuing operations $ (0.11) $ (0.20) $ (0.36) $ (0.37)
Discontinued operations 0.08 -- 0.08 0.78
-------- -------- -------- --------
Net income (loss) $ (0.03) $ (0.20) $ (0.28) $ 0.41
======== ======== ======== ========
Earnings (loss) per share - diluted:
Continuing operations $ (0.11) $ (0.20) $ (0.36) $ (0.37)
Discontinued operations 0.08 -- 0.08 0.78
-------- -------- -------- --------
Net income (loss) $ (0.03) $ (0.20) $ (0.28) $ 0.41
======== ======== ======== ========
Shares used in per share calculation - basic 29,180 29,082 29,144 28,971
======== ======== ======== ========
Shares used in per share calculation - diluted 29,180 29,082 29,144 28,971
======== ======== ======== ========
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
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<TABLE>
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands; unaudited)
<CAPTION>
Nine Months Ended
--------------------------
September 26, September 27,
1999 1998
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (8,111) $ 11,792
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Write-off of minority investment in unaffiliated company -- 3,000
Gain on disposal of discontinued operations (2,246) (22,776)
Loss on disposition of property and equipment 190 --
Depreciation & amortization 4,169 3,695
Deferred income taxes (9) (96)
Amortization of imputed interest on Note receivable (184) --
Amortization of deferred compensation related to stock options 212 62
Changes in assets and liabilities (net of effects of acquisitions):
Accounts receivable (6,883) 431
Inventories 5,187 (3,602)
Other assets 2,650 472
Accounts payable 2,717 925
Accrued liabilities (1,551) (10,971)
Income taxes payable (46) --
Deferred revenue 200 1,172
-------- --------
Net cash used in continuing operations (3,705) (15,896)
Net cash used in discontinued operations (529) (7,173)
-------- --------
Net cash used in operating activities (4,234) (23,069)
-------- --------
Cash flows from investing activities:
Investment in restricted cash (1,400) --
Acquisition of property and equipment (4,927) (2,157)
Loans to employees in exchange for notes receivable (565) (2,289)
Proceeds from sale of discontinued operations -- 54,879
Collection of Note Receivable (Note 2) 3,250 --
Acquisition of S.D.I. (Note 8) (538) --
Acquisition of preferred stock of unaffiliated company -- (3,000)
-------- --------
Net cash provided by (used in)
investing activities (4,180) 47,433
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock, net 279 1,751
Other (124) (146)
-------- --------
Net cash provided by financing activities 155 1,605
-------- --------
Effect of exchange rate changes on
cash and cash equivalents (136) 36
-------- --------
Net increase (decrease) in cash and cash equivalents (8,395) 26,005
Cash and cash equivalents at beginning of year 46,575 22,977
-------- --------
Cash and cash equivalents at end of year $ 38,180 $ 48,982
======== ========
Supplemental disclosures:
Cash paid for income taxes $ -- $ 8,215
Cash paid for interest 3 55
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
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CYLINK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation
The unaudited condensed consolidated financial statements included herein
contain all adjustments, consisting only of normal recurring adjustments which,
in the opinion of management, are necessary to fairly state the consolidated
financial position, results of operations and cash flows of Cylink Corporation
("Cylink" or the "Company") for the periods presented. These interim condensed
consolidated financial statements and notes thereto should be read in
conjunction with Cylink's audited consolidated financial statements and notes
thereto included in Cylink's Annual Report on Form 10-K for the year ended
December 31, 1998. Interim results of operations are not necessarily indicative
of the results to be expected for the fiscal year ending December 31, 1999.
2. Discontinued Operations
On March 27, 1998, Cylink sold its Wireless Communications Group
("Wireless") to P-Com, Inc. for $60.5 million ($46.0 million in cash and an
unsecured promissory note in the amount of $14.5 million due 100 days after
closing, subject to closing adjustments). The sale resulted in an after tax gain
of approximately $22.8 million. As a result, the operations of Wireless have
been classified as discontinued operations in the accompanying Condensed
Consolidated Financial Statements and related Notes. Accrued expenses in the
amount of approximately $6.8 million, primarily for professional services,
anticipated excess facilities expenses, and certain other transaction-related
accruals were charged to discontinued operations and reduced the gain on
disposal. Pursuant to the restatement of revenues and operating results referred
to in Form 10-K for the year ended December 31, 1998, certain revenues of
Wireless previously recognized in the fourth quarter of 1997 and the first
quarter of 1998 were adjusted. Wireless revenues were $4.4 million in the first
quarter of 1998 through the date of disposal.
On July 14, 1998, P-Com made a partial payment on its promissory note, which
along with other credits, totaled $8.9 million. On August 23, 1999, Cylink
accepted as a complete settlement of all outstanding claims and counter-claims a
total of $3.25 million of the outstanding balance. After the elimination of
other claims by Cylink against P-Com and offsetting certain reserves against
those assets, Cylink recorded an additional net gain on disposal of discontinued
operations, net of tax, of $2.2 million.
3. Inventories
September 26, December 31,
-------------------------------------
(in thousands)
Raw materials $ 2,003 $ 2,813
Work in process and subassemblies 615 1,877
Finished goods 2,484 5,599
------- -------
$ 5,102 $10,289
======= =======
4. Earnings (Loss) Per Share
Basic earnings (loss) per share is based on the weighted-average number of
common shares outstanding excluding 306,302 shares escrowed pursuant to the
acquisition of S.D.I. disclosed in Note 8 below. Diluted earnings (loss) per
share is based on the weighted-average number of shares outstanding and dilutive
potential common shares outstanding. Cylink's only potentially dilutive
securities are shares exercisable pursuant to currently outstanding stock
options and escrowed shares. All potentially dilutive securities have been
excluded from the computation of
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diluted earnings (loss) per share as their effect is anti-dilutive on the loss
from continuing operations for the periods presented.
As of September 26, 1999 and September 27, 1998, Cylink had 6,699,000 and
6,081,000 stock options outstanding with a weighted average exercise price of
$4.82 and $9.01, respectively.
5. Comprehensive Loss
<TABLE>
The components of comprehensive loss are as follows (in thousands):
<CAPTION>
Three Months Ended Nine Months Ended
------------------------------- -------------------------------
September 26, September 27 September 26, September 27
1999 1998 1999 1998
-------- -------- -------- --------
(in thousands) (in thousands)
<S> <C> <C> <C> <C>
Net income (loss) $ (992) $ (5,683) $ (8,111) $ 11,792
Other comprehensive income (loss) (88) 35 (136) (27)
-------- -------- -------- --------
Total comprehensive income (loss) $ (1,080) $ (5,648) $ (8,247) $ 11,765
======== ======== ======== ========
</TABLE>
6. New Lease
On May 10, 1999, Cylink reached an agreement to lease approximately 96,000
square feet of office and manufacturing space located in Santa Clara, California
for use as its principal office and manufacturing facility. The lease term is
for 120 months and commenced on September 1, 1999, and includes an option to
extend the lease for an additional 5 years on commercially reasonable terms. The
lease agreement provides for the payment of rent on a net industrial lease basis
commencing at $174,000 per month for the first year and escalating to $228,000
per month in the tenth year of the lease. It is Cylink's intention to sublease
its former manufacturing facility, occupying 34,500 square feet, under its lease
that expires in June 2001, which carries a minimum monthly lease obligation of
$32,775. Cylink's lease on its former headquarters facility expired on September
17, 1999.
On August 5, 1999, Cylink amended its lease for the Santa Clara premises to
add an additional 46,000 square feet directly adjacent to this facility for use
as expansion space. The lease term on the additional space is 119 months
commencing approximately October 1, 1999, and includes an option to extend the
lease for an additional 5 years on commercially reasonable terms. The amended
lease provides for the payment of additional rent on a net industrial lease
basis commencing at $47,513 per month for the first year and escalating to
$57,457 per month in the tenth year of the lease for approximately 22,000 square
feet of the newly added space. The remaining 24,000 square feet of the facility
is currently leased to an outside tenant for a term not exceeding 5 years, after
which the leasehold interest will revert to Cylink on similar terms and
conditions to the initial 22,000 square feet, with rent for this additional
space escalating from $59,100 in the sixth year to $64,025 per month in the
tenth year of the lease.
7. Restricted Cash
As part of the lease agreement referenced in Note 6, the Company posted a
cash deposit in the amount of $1.4 million with its bank to secure a Standby
Letter of Credit in favor of the landlord which serves as an additional security
deposit. The lease agreement provides for the release of all of this portion of
the security deposit after four years upon the achievement of certain financial
profitability goals. Accordingly, Cylink has classified this as a long-term
asset.
8. Business Acquisition
On July 21, 1999, Cylink acquired Virginia-based Security Design
International, Inc. (S.D.I.), a security consulting and professional services
company which provides network vulnerability assessments. Concurrent with the
acquisition, Cylink entered into employment contracts with four S.D.I.
shareholders. In connection with the acquisition and employment agreements,
Cylink (1) paid $450,000 cash, (2) issued 306,302 shares of Cylink common shares
into escrow, to be released in annual installments as the shares vest over a
three-year employment
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period, (3) issued options to purchase 150,000 Cylink common shares which vest
over four years, and (4) agreed to pay bonuses of up to $1.925 million
contingent upon continued employment and the achievement of specified revenue
and profitability goals over three years. Transaction costs totaled
approximately $132,000. Deferred compensation resulting from the issuance of the
escrowed common shares and the stock options totaled approximately $2,034,000
and is reported as a reduction to shareholders equity, to be amortized over the
applicable vesting period. The goodwill resulting from the acquisition
(approximately $436,000) will be amortized over three years. The purchase price
allocation is preliminary and subject to adjustment based on additional
information concerning the fair value of assets acquired and liabilities
assumed. The pro forma results of operations of S.D.I., assuming the acquisition
had occurred as of January 1, 1999, would not be material to Cylink's
consolidated financial statements.
9. Contingencies
Cylink is currently engaged in litigation. See Part II, Item 1. "Legal
Proceedings."
8
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Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Report on Form 10-Q includes statements that reflect Cylink's belief
concerning future events and financial performance. Statements which are not
purely historical in nature are "forward-looking statements" within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. We sometimes identify forward-looking statements with such
words as "expects", "anticipates", "intends", "believes" or similar words
concerning future events.
You should not rely too heavily on these forward-looking statements. They
are subject to certain risks and uncertainties that may cause actual results to
differ materially from past results or Cylink's predictions. For a description
of these risks see Item 2. "Risk Factors That May Affect Future Results," and
other sections of this Report on Form 10-Q. You should also consult the risk
factors listed from time to time in Cylink's other Exchange Act Reports.
All forward-looking statements included in this document are based on
information available to Cylink as of the date of this Report on Form 10-Q, and
Cylink assumes no obligation to update any such forward-looking statements, or
to update the reasons why actual results could differ from those projected in
the forward-looking statements.
DISCONTINUED OPERATIONS
Pursuant to an asset purchase agreement dated March 27, 1998, Cylink sold
its Wireless business to P-Com, Inc. See Note 2 of Notes to Condensed
Consolidated Financial Statements. The sale resulted in an overall after-tax
gain of approximately $25.0 million. Except where noted, the following comments
are associated with the continuing network security business.
RESULTS OF OPERATIONS
<TABLE>
The following table sets forth certain consolidated statement of operations
data as a percentage of revenue for the periods indicated:
<CAPTION>
Three Months Ended Nine Months Ended
------------------ -----------------
Sep 26, Sep 27, Sep 26, Sep 27,
1999 1998 1999 1998
----- ----- ----- -----
<S> <C> <C> <C> <C>
Revenue 100.0% 100.0% 100.0% 100.0%
Cost of revenue 27.5% 48.8% 30.9% 38.5%
----- ----- ----- -----
Gross profit 72.5% 51.2% 69.1% 61.5%
Operating expenses:
Research and development, net 25.1% 51.3% 26.7% 37.0%
Selling and marketing 42.6% 50.9% 42.8% 55.1%
General and administrative 25.2% 20.2% 23.0% 17.8%
Amortization of purchased intangibles 4.8% 5.6% 4.9% 6.3%
----- ----- ----- -----
Total operating expenses 97.6% 128.0% 97.5% 116.1%
----- ----- ----- -----
Loss from operations -25.2% -76.8% -28.4% -54.7%
Other income 3.7% 4.7% 3.9% 4.0%
----- ----- ----- -----
Loss from continuing operations before income taxes -21.5% -72.1% -24.6% -50.7%
===== ===== ===== =====
</TABLE>
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Revenue. Revenue increased 24% from $12.1 million for the three months ended
September 27, 1998 to $15.1 million for the three months ended September 26,
1999, and increased 30% from $32.6 million for the nine months ended September
27, 1998 to $42.2 million for the nine months ended September 26, 1999. These
increases were attributable to increases in unit shipments of existing products,
shipments of products with higher average selling prices, and increased revenues
associated with software maintenance and support services. International revenue
was 38% and 52% of total revenue for the third quarter of 1998 and 1999,
respectively.
Cylink's revenue is derived primarily from sales of its family of commercial
network security products, and to a lesser extent, from the license of software
products. Fees for software maintenance and support services are charged
separately. Revenue arising from sales of hardware products is recognized upon
shipment to customers. Concurrently, a provision is made for estimated cost to
repair or replace products under warranty arrangements. Revenue from sales to
distributors is recognized upon shipment; no right of return, stock rotation or
price protection is given. Revenue from sales to value added resellers is
recognized upon shipment and concurrently a provision for estimated returns is
recorded based on historical and anticipated experience.
Cylink also derives revenue from the license of its software products as
well as fees for software maintenance and support. Cylink's revenue recognition
policy is consistent with Statement of Position 97-2, Software Revenue
Recognition, and the related amendment SOP 98-4. Software license revenue is
recognized when a written purchase order, license agreement or contract has been
executed; delivery of software has occurred; no significant Company obligations
remain; the fee is fixed and determinable; collectibility is probable and
vendor-specific objective evidence exists to allocate the total fee to elements
of the arrangement. Vendor-specific objective evidence is based on the price
generally charged when an element is sold separately. Allowances for estimated
future returns, which to date have been immaterial, are provided upon shipment
and adjusted periodically by management based on historical and anticipated
experience. Maintenance and support revenue consists of ongoing support and
product updates and is deferred and recognized ratably over the term of the
maintenance contract, which is typically twelve months. Software revenue,
including related maintenance and support fees, was not material in any period
presented.
Since its acquisition of S.D.I. in July 1999, Cylink also derives revenues
from network security consulting services. These include vulnerability
assessment, incident response assessment, design review and training, as well as
general consulting services. Services are delivered on either a firm fixed price
or time & materials basis, depending upon customer preference and availability
of required estimating information. Revenue on fixed price services is
recognized on a percentage of completion basis. Some services are rendered on a
time-and-materials basis, and revenue for those services is recognized as the
services are performed. For the quarter ended September 26, 1999, revenue from
professional services was not material.
Gross Profit. Gross profit increased 76.2% from $6.2 million for the three
months ended September 27, 1998 to $10.9 million for the three months ended
September 26, 1999, and increased 46% from $20.0 million for the nine months
ended September 27, 1998 to $29.1 million for the nine months ended September
26, 1999. The increase in dollars was primarily a result of the increase in
revenue. As a percentage of sales, gross profit increased to 72% in the third
quarter of 1999 from 51% for the third quarter of 1998. This increase resulted
primarily from improved manufacturing utilization generating increased overhead
absorbtion and a product mix of higher profit margin products.
Research and Development. Research and development expenses consist
primarily of salaries and other personnel-related expenses, depreciation of
development equipment, facilities and supplies. Research and development
expenses for the third quarter of 1998 included a one-time charge of $3.0
million related to the write off of a minority investment in an unaffiliated
company. Ignoring this one-time charge, gross research and development expenses
increased 7% from $3.9 million for the three months ended September 27, 1998 to
$4.1 million for the three months ended September 26, 1999, and increased 25%
from $10.1 million for the nine months ended September 27, 1998 to $12.5 million
for the nine months ended September 26, 1999. Gross research and development
expenses as a percentage of revenue, ignoring the one-time write off, were 32%
for the third quarter of 1998 compared to 27% for the third quarter of 1999, and
31% for the first nine months of 1998 compared to 30% for the first nine months
of 1999. The dollar increase resulted from increased spending on externally
funded contracts, increased personnel, and development costs of new products,
particularly in Israel. The decrease in expense as a percentage of revenue was
due to an increase in revenue growth at a rate of faster than the growth rate of
spending on new products.
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From time to time Cylink receives engineering funding for development of
projects to apply or enhance Cylink's technology to a particular customer's
need. The amounts recognized under these research and development contracts are
offset against research and development expenses. Amounts recognized under
non-recurring engineering contracts totaled $0.6 million for the third quarter
of 1998 and $0.3 million for the third quarter of 1999, and $1.0 million and
$1.3 million for the first nine months of 1998 and 1999, respectively.
Selling and Marketing. Selling and marketing expenses consist primarily of
personnel expenses, including sales commissions, and expenses for advertising,
public relations, seminars and trade shows. Selling and marketing expenses
increased 4% from $6.2 million for the three months ended September 27, 1998 to
$6.4 million for the three months ended September 26, 1999, and increased 1%
from $18.0 million for the nine months ended September 27, 1998 to $18.1 million
for the nine months ended September 26, 1999. Selling and marketing expenses as
a percentage of revenue were 51% for the third quarter of 1998 compared to 43%
for the third quarter of 1999, and 55% for the first nine months of 1998
compared to 43% for the first nine months of 1999. These modest spending
increases were primarily due to increased travel related costs attributable to
further development of Cylink's US channels organization and higher occupancy
costs. Selling and marketing expenses, expressed as a percentage of revenue,
decreased as a result of the increased revenue base.
General and Administrative. General and administrative expenses consist
primarily of personnel and related costs, recruitment expenses, information
systems costs, and audit, legal and other professional service fees. General and
administrative expenses increased 55% from $2.5 million for the three months
ended September 27, 1998 to $3.8 million for the three months ended September
26, 1999, and increased 68% from $5.8 million for the nine months ended
September 26, 1998 to $9.7 million for the nine months ended September 26, 1999.
General and administrative expenses as a percentage of revenue were 20% for the
third quarter of 1998 compared to 25% for the third quarter of 1999, and 18% for
the first nine months of 1998 compared to 23% for the first nine months of 1999.
The dollar and percentage of revenue increases in the third quarter of 1999 were
primarily due to non-capitalized training and supply costs associated with
Cylink's new Enterprise Resource Planning system, relocation and excess
facilities costs, an additional provision for doubtful accounts of $.2 million
and additional professional services costs.
Amortization of Purchased Intangibles. Amortization relating to goodwill and
other intangibles was $0.7 million in each period presented and relates to the
acquisition of Algorithmic Research, Ltd and Algart Holdings, Ltd. (collectively
"ARL") in September 1997, and the acquisition of S.D.I. in the third quarter of
1999.
Benefit from Income Taxes. No provision for, or benefit from, income taxes
was recognized in the quarter ended September 26, 1999 as Cylink incurred a net
operating loss for income tax purposes and had no additional loss carryback
potential.
Other Income (Expense), Net. Other income (expense), net, consists primarily
of interest income, interest expense and, to a lesser extent, royalty income.
Interest income, net, decreased from $0.5 million for the third quarter of 1998
to $0.4 million for the third quarter of 1999, principally due to lower cash and
cash equivalent balances between periods.
LIQUIDITY AND CAPITAL RESOURCES
At September 26, 1999, Cylink had cash and cash equivalents of $38.2
million, working capital of $49.5 million and minimal long-term obligations. For
the nine months ended September 26, 1999, Cylink recorded a net loss of $8.1
million. Operating activities used $4.2 million in the nine months ended
September 26, 1999. This consisted primarily of the loss from continuing
operations and an increase in accounts receivable of $6.9 million, offset in
part by a decrease in inventories of $5.2 million Both the increase in accounts
receivable and the decrease in inventories were the result of increased sales.
For the nine months ended September 27, 1998, Cylink recorded net income of
$11.8 million, principally due to the $22.8 million gain on sale of Wireless,
offset by a loss from continuing operations of $10.7 million and a loss from
discontinued operations of $.3 million. For the first nine months of 1998
continuing operations used $15.9 million. This consisted primarily of the loss
from continuing operations of $10.7 million, increases in inventories in
anticipation of increased sales and payment of estimated income taxes related to
the gain on sale of Wireless.
Investing activities for the nine months ended September 26, 1999 used $4.2
million in cash. These expenditures consisted primarily of investments in fixed
assets totaling $4.9 million, the investment of $1.4 million in restricted
11
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cash to secure a standby letter of credit, long-term loans to employees of $.6
million, and a $.5 million cash investment in S.D.I., offset in part by the
collection of a note receivable of $3.25 million. The investments in fixed
assets consisted primarily of the license and implementation costs of an Oracle
Enterprise Resource Planning system, the acquisition of related computer
hardware, and tenant improvements and furniture in connection with Cylink's new
lease. Cash provided by investing activities for the nine months ended September
27, 1998 was $47.4 million, of which $54.9 million was attributed to the sale of
Wireless. The funds attributable to the Wireless sale were partially offset by
expenditures for property and equipment of $2.2 million, long-term loans to
employees of $2.2 million, and a $3.0 million minority investment in the
preferred stock of an unaffiliated company.
Cylink is currently engaged in litigation. See Part II, Item 1. "Legal
Proceedings." Management believes that the ultimate resolution of these matters
will not have a material adverse effect on Cylink's financial position or
results of operations.
On July 21, 1999, Cylink acquired Virginia-based Security Design
International, Inc.("S.D.I."), for a $450,000 cash payment, issuance of
approximately 306,000 shares of Cylink's common stock, and a deferred cash bonus
of up to $1.925 million. In connection with the terms of the acquisition, Cylink
recorded a non-cash, deferred compensation charge of $1.8 million resulting from
the issuance of the 306,000 shares, which will be amortized over the life of the
underlying employment agreements, and a non-cash, deferred compensation charge
predicated on the difference between market value of the underlying shares and
the option exercise price on the date of the grant applied to 150,000 options
granted in connection with the employment by the Company of the selling
shareholders of S.D.I., to be amortized over the vesting period of those
options. Cylink recorded as goodwill approximately $.5 million excess of the
purchase consideration over the identifiable fair value of the net assets
obtained, to be amortized over three years. In addition to the acquisition cost,
S.D.I. is expected to utilize approximately $0.5 million in capital equipment
and operating loss requirements over the next 12 months.
Cylink believes that existing cash balances and cash generated from
operations, if any, will be sufficient to fund necessary purchases of capital
equipment and to provide working capital through at least the next twelve
months. However, Cylink may require additional funds to support its continuing
operating losses, working capital requirements or for other purposes and may
seek to raise such additional funds through public or private equity financing
or from other sources. This additional financing may not be available on terms
favorable to Cylink or its shareholders, if at all.
Year 2000 Compliance
"Year 2000 Compliance" refers generally to the problems that some software,
including firmware embedded in Cylink's products, may have in determining the
correct century for the year. For example, software with date-sensitive
functions that is not Year 2000 compliant may not be able to distinguish whether
"00" means 1900 or 2000, which may result in failures or the creation of
erroneous results. Cylink has defined "Year 2000 Compliant" as the ability to:
(i) correctly handle date information needed for the December 31, 1999 to
January 1, 2000 date change; (ii) function according to the product
documentation provided for this date change, without changes in operation
resulting from the advent of a new century, assuming correct configuration;
(iii) where appropriate, respond to two-digit date input in a way that resolves
the ambiguity as to century in a disclosed, defined, and predetermined manner,
such as in certificate based products, or in accordance with Cylink's Year 2000
Compliant test plan; and (iv) recognize year 2000 as a leap year.
Cylink has developed a Year 2000 readiness plan for the current versions of
its products. Cylink has largely completed all phases of its plan, except for
contingency planning, with respect to the current versions of all of its
products. As a result, the current versions of each of its products currently
offered for sale are believed to be "Year 2000 Compliant." In some cases,
Cylink's products require an upgrade provided by Cylink which is either sold as
a complete substitute or as a kit sold with the product in order to be Year 2000
Compliant.
Cylink has completed a review of its mission critical internal information
systems (including the third-party software for its management information
systems, networks and desktop applications, and its hardware telecommunications
technology) and believes it has addressed all critical concerns. When
deficiencies have been identified in critical components, Cylink is purchasing
new or upgraded versions which have been certified by their vendors as
compliant.
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Cylink has funded its Year 2000 plan from operating cash. While Cylink does
not expect such costs to be material, Cylink will incur additional amounts
related to the Year 2000 plan for administrative personnel to manage Cylink's
readiness plans, technical support for its product engineering and customer
satisfaction.
Cylink has completed its plans to address Year 2000 readiness of its
critical operations based on its perception of the known risks involved.
Despite testing by Cylink and current and potential customers, and any
assurances from developers of products incorporated into Cylink's products or in
use in Cylink's business operations, Cylink's products may contain undetected
errors or defects associated with Year 2000 date functions. Further, Cylink may
be using products in its business operations which are not Year 2000 compliant.
An unanticipated Year 2000 interruption could have material adverse financial
consequences to Cylink or seriously impair business operations for an indefinite
period of time.
For a more comprehensive discussion of Cylink's Year 2000 plans and
exposures, see the "Year 2000" topic under Part I, Item 2. "Risk Factors That
May Affect Future Results."
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RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
Recent Losses; Potential Fluctuations in Operating Results, Future Operating
Results Uncertain
Cylink incurred losses from continuing operations in 1998 and for each of
the prior four years. Cylink expects to continue to incur net losses through at
least the balance of 1999. Cylink may not increase or maintain its revenue or be
profitable on a quarterly or an annual basis in the future.
Cylink has historically experienced significant fluctuations in its
operating results on a quarterly basis and could experience such fluctuations in
the future. Cylink's operating results are affected by a number of factors, many
of which are outside of Cylink's control, including the following:
o the timing of the introduction of new or enhanced products by Cylink or its
competitors
o market acceptance of new products of Cylink, new products of its customers,
and new product introductions by its competitors
o the timing, cancellation or delay of customer orders, including cancellation
or delay in anticipation of new product introduction or enhancement or
resulting from uncertainty relating to intellectual property claims
o competitive factors, including pricing pressures
o changes in operating expenses, including those resulting from changes in
available production capacity of independent foundries and other suppliers
and the availability of raw materials
o delays in manufacturing due to shortages in components or unanticipated
revisions in product design
o expenses incurred in seeking to obtain, enforce and defend claims with
respect to intellectual property rights
o the mix of products sold
o changes in the percentage of products sold through Cylink's direct sales
force
o personnel changes
o general economic conditions, and,
o fluctuations in foreign currency exchange rates.
Cylink expects to introduce a number of new products during the remainder of
1999 and 2000. The failure of any such products to achieve market acceptance
when anticipated, or at all, would materially and adversely affect Cylink's
financial condition and results of operations.
In connection with the acquisition of ARL in September 1997, Cylink
allocated $63.9 million of the purchase price to in-process research and
development ("IPR&D"), and in accordance with generally accepted accounting
principles recorded an immediate charge off of that amount on the date of
acquisition. The amount allocated to IPR&D was determined in a manner consistent
with widely recognized appraisal practices.
In a letter dated September 15, 1998, to the American Institute of Certified
Public Accountants, the Chief Accountant of the Securities and Exchange
Commission ("SEC") indicated the SEC Staff's concerns related to certain
appraisal practices generally employed in determining the fair value of IPR&D.
As a result, it is possible that the SEC staff may require that any enterprise
that recorded an IPR&D charge revise its estimate of the value of the IPR&D. To
the extent Cylink is required by the SEC Staff to retroactively revise its
estimate of the value of IPR&D, such revision could result in the capitalization
of additional goodwill, the amortization of which would reduce future operating
results.
Lengthy Sales Cycle
Sales of Cylink's products generally involve a significant commitment of
capital by customers, with the attendant delays frequently associated with large
capital expenditures. For these and other reasons, the sales cycle associated
with Cylink's products is typically lengthy and subject to a number of
significant risks over which Cylink has little or no control. Cylink is often
required to ship products shortly after it receives orders and, consequently,
order backlog at the beginning of any period has in the past represented only a
small portion of that period's expected revenue. As a result, product revenue in
any period is substantially dependent on orders booked and shipped in that
period. Cylink typically plans its production and inventory levels based on
internal forecasts of customer demand, which are highly unpredictable and can
fluctuate substantially. In addition, Cylink's current or future customers may
curtail or suspend investments in securing their existing networks as the Year
2000 approaches, or divert technology expenditures reserved for enterprise
security products in order to address Year 2000 compliance problems (see further
discussion
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under Year 2000 below). If revenue falls significantly below anticipated levels,
as it has at times in the past, Cylink's financial condition and results of
operations would be materially and adversely affected. In addition, Cylink's
operating expenses are based on anticipated revenue levels and a high percentage
of Cylink's expenses are generally fixed in the short term. Based on these
factors, a small fluctuation in the timing of sales can cause operating results
to vary significantly from period to period. For example, on September 14, 1998,
Cylink announced that its earnings for the third quarter of 1998 would be below
consensus estimates. It is possible that in the future Cylink's operating
results will again be below the expectations of securities analysts and
investors. In such an event, or in the event that adverse conditions prevail or
are perceived to prevail generally or with respect to Cylink's business, the
price of Cylink's Common Stock would likely be materially adversely affected.
Pending Litigation
See Part II, Item 1. "Legal Proceedings."
Dependence on Key Personnel
On November 4, 1998, Mr. William C. Crowell, formerly Vice President of
Product Strategy, was promoted to President and Chief Executive Officer, and on
November 16, 1998, Mr. Roger A. Barnes became Cylink's Chief Financial Officer.
Cylink's future success will depend on the abilities of Mr. Crowell and the
contributions by its other executive officers, key management and technical
personnel. The loss of the services of one or more of Cylink's executive
officers or key personnel, or the inability to continue to attract and retain
qualified personnel, could delay product development cycles or otherwise have a
material adverse effect on Cylink's business and operating results.
Dependence on Recently Introduced and New Information Security Products
Cylink's future results of operations will be highly dependent on the
successful completion of the design, development, introduction, marketing and
manufacture of Cylink's virtual private networking ("VPN") hardware product and
commercial versions of its public key infrastructure ("PKI") products, as well
as successful marketing and manufacture of the Cylink Link Encryptors, PrivaCy
Manager, PrivateWire and Cylink Frame Encryptor products. To date, Cylink has
made only limited, and, in some cases, no commercial shipments of certain
versions of such products. These products may require additional development
work, enhancement, testing or further refinement before they can achieve or in
order to maintain market acceptance. In this regard, Cylink relies on a third
party original equipment manufacturer to supply Cylink's ATM Encryptor product,
and Cylink is dependent on this supplier for continued development, manufacture
and support. If any of Cylink's products have performance, reliability, quality
or other shortcomings, then such products could fail to achieve or maintain
market acceptance. The failure by Cylink's new or existing products to achieve
or enjoy market acceptance, whether for these or other reasons, could cause
Cylink to experience reduced orders, higher manufacturing costs, delays in
collecting accounts receivable and additional warranty and service expenses,
which in each case could have a material adverse effect on Cylink's business,
financial condition and results of operations.
Competition
Competition is intense among providers of network security systems, and
Cylink expects such competition to increase in the future. Significant
competitive factors in these markets include:
o the development of new products and features
o product quality and performance
o the quality and experience of sales, marketing and service organizations
o product price
o name recognition, and,
o perception of Company stability and long-term viability.
Many of these factors are beyond Cylink's control. In addition, some
factors, such as the perception of Cylink's stability and viability over the
long term may have been adversely affected by the December 1998 restatement of
Cylink's 1997 and first and second quarter 1998 financial statements, which
could materially adversely impact Cylink's ability to compete.
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Cylink's competitors in the information security markets, including
companies that offer products similar to or as an alternative to Cylink's
products, include Axent Technologies, Inc., Checkpoint Software Technologies,
Ltd., Network Associates, Inc., Secure Computing Corporation, RSA Security,
Inc., Racal-Guardata, Inc., and Information Resource Engineering, Inc. Cylink's
OEM supplier of its ATM Encryptor product also competes with Cylink, through
distribution channels, for sales of this product. In addition, Northern Telecom
Limited, AT&T, Motorola Corporation, and Sun Microsystems, Inc. offer certain
information security products as part of their overall networking solutions. A
number of significant vendors, including Microsoft Corporation, Netscape
Communications Corporation and Cisco Systems, Inc., have embedded security
solutions in their software. To the extent that these embedded or optional
security capabilities provide all or a portion of the functionality provided by
Cylink's products, Cylink's products may no longer be required by customers to
attain network security.
Certicom Corporation and RSA Security, Inc. ("RSASI"), license various
methods of implementing public key cryptography, including some that are
different from (and incompatible with) the method of implementing public key
cryptography currently used by Cylink in most of its products. Although Cylink
has a license to use all of the public key methods promoted by Certicom and
RSASI, to the extent significant segments of the network security market adopt
technical standards different from those currently used by Cylink, to the
exclusion of Cylink's methods, sales of Cylink's existing and planned products
in that market segment may be adversely impacted, which could have a material
adverse effect on Cylink's financial condition and results of operations.
Many of Cylink's competitors have substantially greater financial,
technical, marketing, distribution and other resources, greater name recognition
and longer standing relationships with customers than Cylink. Competitors with
greater financial resources are better able to engage in sustained price
reductions in order to gain market share. Any period of sustained price
reductions would have a material adverse effect on Cylink's financial condition
and results of operations. Cylink may not be able to compete successfully in the
future and competitive pressures may result in price reductions, loss of market
share or otherwise have a material adverse effect on Cylink's financial
condition and results of operations.
Product Liability Risks
Customers rely on Cylink's network security products to prevent unauthorized
access to their networks and data transmissions. A malfunction or the inadequate
design of Cylink's products could result in tort or warranty claims. Although
Cylink attempts to reduce the risk of such losses through warranty disclaimers
and liability limitation clauses in its sales and license agreements and by
maintaining product liability insurance, there can be no assurance that such
measures will be effective in limiting Cylink's liability for any such damages.
Any liability for damages resulting from security breaches could be substantial
and could have a material adverse effect on Cylink's business, financial
condition and results of operations.
In addition, a well-publicized actual or perceived security breach could
adversely affect the market's perception of security products in general, or
Cylink's products in particular, regardless of whether such breach is
attributable to Cylink's products. This could result in a decline in demand for
Cylink's products, which would have a material adverse effect on Cylink's
business, financial condition and results of operations.
Year 2000
The "Year 2000 Issue" refers generally to the problems that some software,
including firmware embedded in Cylink's products, may have in determining the
correct century for the year. For example, software with date-sensitive
functions that is not Year 2000 compliant may not be able to distinguish whether
"00" means 1900 or 2000, which may result in failures or the creation of
erroneous results.
Cylink has developed a Year 2000 readiness plan for the current versions of
its products. The plan includes development of corporate awareness, assessment,
implementation (including remediation, upgrading and replacement of certain
product versions), validation testing, and contingency planning. Cylink
continues to respond to customer concerns about prior versions of its products
on a case-by-case basis.
Cylink has largely completed all phases of its plan, except for contingency
planning, with respect to the current versions of all of its products. As a
result, the current versions of each of its products currently offered for sale
are believed to be "Year 2000 Compliant" as defined below when configured and
used in accordance with the related
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documentation, and provided that the underlying operating system of the host
machine and any other software used with or in the host machine or Cylink's
products are also Year 2000 Compliant. In some cases, Cylink's products require
an upgrade provided by Cylink which is either sold as a complete substitute or
as a kit sold with the product in order to be Year 2000 Compliant.
Cylink has defined "Year 2000 Compliant" as the ability to: (i) correctly
handle date information needed for the December 31, 1999 to January 1, 2000 date
change; (ii) function according to the product documentation provided for this
date change, without changes in operation resulting from the advent of a new
century, assuming correct configuration; (iii) where appropriate, respond to
two-digit date input in a way that resolves the ambiguity as to century in a
disclosed, defined, and predetermined manner, such as in certificate based
products, or in accordance with Cylink's Year 2000 Compliant test plan; and (iv)
recognize year 2000 as a leap year. Cylink has not tested its products on all
platforms or all versions of operating systems that it currently supports and
has advised its customers to verify that their platforms and operating systems
support the transition to the year 2000.
Cylink has not specifically tested software obtained from third parties
(licensed software, shareware, and freeware) that is incorporated into its
products, but Cylink's test plan was designed to reveal Year 2000 deficiencies
with third party software incorporated in Cylink's products.
Despite testing by Cylink and current and potential customers, and any
assurances from developers of products incorporated into Cylink's products,
Cylink's products may contain undetected errors or defects associated with Year
2000 date functions. Also, certain prior versions of Cylink's products are not
fully Year 2000 Compliant, and Cylink is working to address these issues by
offering for sale upgrades to compliant versions. Known or unknown errors or
defects in Cylink's products could result in delay or loss of revenue, diversion
of development resources, damage to Cylink's reputation, or increased service
and warranty costs, any of which could materially adversely affect Cylink's
business, operating results, or financial condition.
Cylink does not currently have any information concerning the Year 2000
compliance status of its customers. If Cylink's current or future customers
suspend investments in securing their existing networks while they achieve Year
2000 compliance, or if they divert technology expenditures (especially
technology expenditures that are reserved for enterprise security products) to
address Year 2000 compliance problems, Cylink's business, results of operations,
or financial condition could be materially adversely affected.
Some commentators have predicted significant litigation regarding Year 2000
compliance issues. Because this type of litigation lacks precedent, it is
uncertain whether or to what extent Cylink may be affected by it.
Cylink has completed a review of its mission critical internal information
systems (including the third-party software for its management information
systems, networks and desktop applications, and its hardware telecommunications
technology) and believes it has addressed all critical concerns. To the extent
that Cylink is not been able to test the technology provided by third-party
vendors, Cylink will purchase upgrades for versions which have been certified by
their vendors as compliant. Although Cylink is not currently aware of any
material operational issues or costs associated with preparing its internal
information systems for the Year 2000, Cylink may experience material
unanticipated problems and costs caused by undetected errors or defects in the
technology used in its information systems.
Cylink has funded its Year 2000 plan from operating cash. While Cylink does
not expect such costs to be material, Cylink will incur additional amounts
related to the Year 2000 plan for administrative personnel to manage Cylink's
readiness plans, technical support for its product engineering and customer
satisfaction. Cylink may experience material problems and costs with Year 2000
compliance that could adversely affect Cylink's business, results of operations,
and financial condition.
Finally, Cylink is also subject to external forces that might generally
affect industry and commerce, such as utility or transportation company Year
2000 compliance failures and related service interruptions.
Cylink has completed its plans to address Year 2000 readiness of its
critical operations based on its perception of the known risks involved.
However, were Cylink to experience an unanticipated Year 2000 interruption,
business operations could be seriously impaired for an indefinite period of time
until remedial efforts could be achieved.
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Management of Growth In Employees
Cylink has recently and may continue to experience substantial fluctuations
in the number of employees and the scope of its operations in the network
security business, resulting in increased responsibilities for management. To
manage its business effectively, Cylink will need to continue to improve its
operational, financial and management information systems and to hire, train,
motivate and manage its employees. Competition is intense for qualified
technical, marketing and management personnel, particularly highly skilled
engineers. In particular, the current availability of qualified engineers is
quite limited, and competition among companies, academic institutions,
government entities and other organizations for skilled and experienced
engineering personnel is very intense. Cylink has experienced delays in filling
positions for engineering personnel and Cylink expects to experience continued
difficulty in filling its needs for qualified engineers and other personnel.
There can be no assurance that Cylink will be able to effectively achieve or
manage any future growth, and its failure to do so could delay product
development cycles or otherwise have a material adverse effect on Cylink's
financial condition and results of operations.
In September 1997, Cylink acquired Algorithmic Research, Ltd. ("ARL") and
assumed responsibility for management of its worldwide operations which
currently consists of approximately eighty-four employees. Cylink is heavily
dependent on ARL's success in continuing to develop marketable technology and
products, such as the PrivateWire family, including PrivateSafe and PrivateCard,
toolkits and other components, as well as Cylink's next generation hardware VPN
product. Key factors which will determine ARL's success include whether Cylink
can adequately fund ARL's development objectives, whether Cylink can provide
accurate information for ARL to focus its technology on significant market
opportunities, and whether Cylink can predict the most attractive features and
functions for ARL's products. Cylink's success in realizing the anticipated
return from its investment in ARL also will be determined by Cylink's ability to
position and introduce ARL's products into Cylink's markets and channels, and
Cylink's ability to provide adequate sales and customer support for ARL's
products. To date, Cylink's efforts to market ARL's products through Cylink's
direct sales channel have not met Cylink's expectations due to differences
between the sales expertise required for selling the ARL products and that
required for Cylink's other products. Consequently, Cylink has recently
reorganized the management of ARL to strengthen ARL's responsibility for
marketing and sales of its products. In addition, ARL's improvements and
development of new products have been delayed by inadequate coordination between
engineering departments located in Santa Clara, CA and Petach Tikva, Israel.
This inadequate coordination to date is due to differing engineering practices
concerning development planning and restrictions imposed by U.S. export control
laws governing the transfer of cryptographic expertise. Cylink and ARL's
successful working relationship may be hindered significantly by differences
between the two organizations created by time, distance, language and culture.
ARL operates from its principal offices in Israel, a country which is vulnerable
to disruption due to the sudden outbreak of hostilities with its neighbors and
various indigenous factions. Many of ARL's employees have extensive commitments
to the country's military organizations which may require a loss of their
services on the Company's behalf in times of political instability.
Cylink's recent acquisition of S.D.I. requires management of their
professional services in a market where Cylink has limited experience. S.D.I.'s
employee morale and reputation for providing objective assessments on its
clients' network security may be adversely affected by this acquisition,
particularly if S.D.I.'s prospective clients believe S.D.I.'s recommendations
are biased in favor of Cylink's products and services. The success of S.D.I.'s
business is critically dependent on S.D.I.'s ability to attract and retain
qualified employees, and S.D.I.'s present employees may not accept the influence
of Cylink's management and loss of autonomy they once enjoyed.
Intellectual Property and Other Proprietary Rights
Cylink relies on patents, trademarks, copyrights, licenses and trade secret
law to establish and preserve its intellectual property rights. Cylink owns a
number of U.S. patents covering certain aspects of its network security product
designs, and has additional U.S. patent applications pending. There can be no
assurance that any patent, trademark, copyright or license owned or held by
Cylink will not be invalidated, circumvented or challenged, that the rights
granted thereunder will provide competitive advantages to Cylink or that any of
Cylink's pending or future patent applications will be issued with the scope of
the claims sought by Cylink, if at all. Further, there can be no assurance that
others will not develop technologies that are similar or superior to Cylink's
technology, duplicate Cylink's technology or design around the patents owned by
Cylink. Cylink may be subject to or may initiate interference proceedings in the
U.S. Patent Office, which can require significant financial and management
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resources. In addition, the laws of certain countries in which Cylink's products
are or may be developed, manufactured or sold may not protect Cylink's products
and intellectual property rights to the same extent as the laws of the United
States. The inability of Cylink to protect its intellectual property adequately
could have a material adverse effect on its financial condition and results of
operations.
The computer, communications, software and network security industries are
characterized by substantial litigation regarding patent and other intellectual
property rights. From time to time, Cylink has received communications from
third parties asserting that Cylink's patents, features or content of certain of
Cylink's products infringe upon the intellectual property rights held by third
parties, and Cylink may receive such communications in the future. There can be
no assurance that third parties will not assert claims against Cylink that
result in litigation. Any litigation, whether or not determined in favor of
Cylink, could result in significant expense to Cylink and could divert
management and other resources. In the event of an adverse ruling in any
litigation involving intellectual property, Cylink might be required to
discontinue the use of certain processes, cease the manufacture, use and sale of
infringing products, expend significant resources to develop non-infringing
technology or obtain licenses to the infringing technology and may suffer
significant monetary damages, which could include treble damages. There can be
no assurance that under such circumstances a license would be available to
Cylink on reasonable terms or at all. In the event of a successful claim against
Cylink and Cylink's failure to develop or license a substitute technology on
commercially reasonable terms, Cylink's financial condition and results of
operations would be adversely affected. There can be no assurance that existing
claims or any other assertions (or claims for indemnity from customers resulting
from infringement claims) will not materially and adversely affect Cylink's
financial condition and results of operations.
Evolving Network Security Market; Market Acceptance Risks
The market for Cylink's network security products is relatively new and is
still evolving. This market is characterized by rapidly changing technology,
emerging industry standards, new product introductions and changes in customer
requirements and preferences. Cylink's future success will depend in part upon
end users' demand for network security products in general, and upon Cylink's
ability to enhance its existing products and to develop and introduce new
products and technologies that meet customer requirements. Cylink faces
continuing challenges to educate customers as to the value of its security
products. Cylink believes that many potential customers do not appreciate the
need for high-end security products unless and until they have faced a major
security breach. If Cylink is unable to successfully educate potential customers
as to the value of, and thereby obtain broad market acceptance for, its
products, it will continue to rely primarily on selling new and existing
products to its base of existing customers, which will significantly limit any
opportunity for growth. In addition, any significant advance in technologies for
attacking cryptographic systems could render some or all of Cylink's existing
and new products obsolete or unmarketable. To the extent that a specific method
other than Cylink's is adopted as the standard for implementing network security
in any segment of the network security market, sales of Cylink's existing and
planned products in that market segment may be adversely impacted, which could
have a material adverse effect on Cylink's business, financial condition and
results of operations. See "Competition." Network security-related products or
technologies developed by others may adversely affect Cylink's competitive
position or render its products or technologies noncompetitive or obsolete.
Rapid Technological Change
The markets for Cylink's products are characterized by rapidly changing
technologies, extensive research and new product introductions. Cylink believes
that its future success will depend in part upon its ability to continue to
enhance its existing products and to develop, manufacture and market new
products. As a result, Cylink expects to continue to make a significant
investment in engineering, research and development. Cylink may not be able to
develop and introduce new products or enhancements to its existing products in a
timely manner which satisfy customer needs, achieve market acceptance or address
technological changes in its target markets. The failure of Cylink to develop
products and introduce them successfully and in a timely manner could adversely
affect Cylink's competitive position, financial condition and results of
operations.
Risks Associated with International Sales; Reliance Upon Local Partners;
Restrictions on Export
Cylink plans to continue to expand its foreign sales channels and to enter
additional international markets, both of which will require significant
management attention and financial resources. International sales are subject to
a
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number of risks, including unexpected changes in regulatory requirements, export
control laws, tariffs and other trade barriers, political and economic
instability in foreign markets, difficulties in the staffing, management and
integration of foreign operations, longer payment cycles, greater difficulty in
collecting accounts receivable, currency fluctuations and potentially adverse
tax consequences. Since most of Cylink's foreign sales are denominated in U.S.
dollars, Cylink's products become less price competitive in countries in which
local currencies decline in value relative to the U.S. dollar. The uncertainty
of monetary exchange values has caused, and may in the future cause, some
foreign customers to delay new orders or delay payment for existing orders. The
long-term impact of such devaluation, including any possible effect on the
business outlook in other developing countries, cannot be predicted.
Cylink's ability to compete successfully in foreign countries is dependent
in part on Cylink's ability to obtain and retain reliable and experienced
in-country distributors and other strategic partners. Cylink does not have
long-term relationships with any of its value added resellers and distributors
and, therefore, has no assurance of a continuing relationship within a given
market.
Due to U.S. and Israeli government regulations restricting the export of
cryptographic devices and software, including certain of Cylink's network
security products, Cylink is often at a disadvantage in competing for
international sales compared to companies located outside the United States and
Israel that are not subject to such restrictions. Cylink is unable to offer its
products to certain types of foreign customers and, on occasion, has lost sales
due to uncertainty over whether Cylink will be permitted to sell its products.
The regulatory environment in the United States for export of encryption
products is particularly unsettled, with various pending legislative initiatives
and conflicting judicial decisions, all causing substantial uncertainty in
Cylink's international market. This confusion is often exacerbated by U.S.
vendors' incomplete or inaccurate press releases concerning export licenses for
their products, and foreign competitors marketing campaigns which stress the
restrictions on purchasing encryption products from U.S. vendors. There is no
assurance that this disruption will end anytime within the near future.
Dependence on Component Availability, Subcontractor Performance and Key
Suppliers
Cylink's ability to deliver its products in a timely manner is dependent
upon the availability of quality components and subsystems used in these
products. Cylink depends in part upon subcontractors to manufacture, assemble
and deliver certain items in a timely and satisfactory manner. Cylink obtains
certain components and subsystems from single, or a limited number of, sources.
In particular, Cylink relies on a single OEM supplier for Cylink's ATM product,
which Cylink offers to its customers with its own management solution. A
significant interruption in the delivery of such items could have a material
adverse effect on Cylink's financial condition and results of operations.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Cylink's market risk exposures are set forth in its Annual Report on Form
10-K for the year ended December 31, 1998 and have not changed significantly.
20
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On September 14, 1998, Cylink announced that its earnings for the third
quarter of 1998 would be below consensus estimates. On November 5, 1998, Cylink
announced that, with the assistance of its independent accountants, it was
reviewing its revenue recognition practices, and Cylink announced that its first
and second quarter earnings of 1998 would have to be restated and that it would
have operating losses for each of the three quarters for the period ended
September 27, 1998. During the review, certain facts became known indicating
errors had been made in the application of revenue recognition policies which
also impacted the fourth quarter of 1997, and as a result, 1997 full-year
results have been restated along with first and second quarter 1998 results.
Cylink has filed amended Forms 10-Q for the first and second quarters of 1998
and an amended Form 10-K for 1997. Between November 6 and November 25, 1998,
several securities class action complaints were filed against Cylink and certain
of its current and former directors and officers in federal courts in
California. These complaints allege, among other things, that Cylink's
previously issued financial statements were materially false and misleading and
that the defendants knew or should have known that these financial statements
caused Cylink's common stock price to rise artificially. The actions variously
allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the
"Exchange Act"), as amended, and SEC Rule 10b-5 promulgated thereunder, and
Section 20 of the Exchange Act.
Cylink believes it has meritorious defenses to these actions and intends to
defend itself vigorously. However, it is not feasible to predict or determine
the final outcome of these proceedings, and if the outcome were to be
unfavorable, Cylink's business, financial condition, cash flows and results of
operations could be materially adversely affected.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
Exhibit
Number Description of Exhibit
------ ----------------------
27.1 Financial Data Schedule for the fiscal quarter ended September
26, 1999
(b) Reports on Form 8-K.
Cylink filed a report on Form 8-K on July 19, 1999 as required by
Item 4 of Form 8-K with respect to a change in accountants. On July 12,
1999, Cylink retained Deloitte & Touche LLP as its independent
accounting firm and dismissed PricewaterhouseCoopers LLP. The change in
the independent accountants was approved by the Audit Committee of
Cylink's Board of Directors and does not reflect any disagreements with
PricewaterhouseCoopers LLP over matters of accounting principles or
practices, financial statement disclosure, or auditing scope or
procedure.
Items 2, 3, 4 and 5 are not applicable and have been omitted.
21
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Date: November 9, 1999 CYLINK CORPORATION
By: /s/ ROGER A. BARNES
------------------------------
Roger A. Barnes
Vice President of Finance
and Administration and
Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
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